By Brad Whitfield, CPA, CVA
Many times business owners execute a buy-sell agreement, file it away and forget about it or worse, they do not have one at all. A buy-sell agreement is a contract among business owners defining ownership transition within a company. Three important factors for business owners to consider in buy-sell agreements are the parties’ original intentions, how the price is determined, and the funding mechanism.
Parties’ Intentions
The buy-sell agreement (BSA) is put into action when a “triggering event” occurs. Common events that trigger the BSA include, but are not limited to, death, retirement, disability or employment termination. The original parties’ intentions must be clearly stated in the BSA before one of the triggering events occurs. Once the BSA is triggered, owners cannot change the content of the agreement. Owners usually intend to bring fairness and expediency to the transition of ownership. The parties seek to avoid long delays, costly legal expenses, and anxiety for them and their heirs. Business owners should make sure that the current BSA in place contains language that clearly states their intentions.
Determination of the Price
The price paid or received after the BSA has been triggered is usually the most controversial and disputed element. Typically the price is determined by one of three ways: fixed-price agreements, formula agreements, or valuation process agreements.
Fixed Price
Under a fixed-price agreement, all business owners simply agree upon a price to pay each person after a triggering event occurs. Although this agreement is the simplest of the three, several problems may exist. The fixed price must be updated at least annually and is likely out of date. The current value of the business may be higher or lower than the agreed upon price at the execution date, which exposes either party to risk.
Predetermined Formula
The formula agreement is where business owners agree upon a formula to calculate the price. Often the formula agreement states that a single formula be applied to a combination of the balance sheet and/or income statement of the business. However, the agreed upon formula may not be representational of the current value or fair market value of the business. Fair market value must be used for gift and estate tax purposes under Internal Revenue Code and Regulations.
The business’s financial statements may exclude intangible assets, such as goodwill, which may be the company’s largest asset. Many times small business’s financial statements may be prepared on the cash basis which exclude items such as accounts receivable and accounts payable. Omitting such items when determining the price could be costly to either party involved. All parties involved should be able to apply the formula and come up with the same price.
The formula agreement can withstand a few years of activity without updating, but should be reviewed.
Valuation Process
The valuation process agreement involves business owners choosing a business appraiser to set the price. An independent business valuation appraiser may be engaged to determine the value of the business before or after one of the triggering events occurs.
Owners’ legal and valuation professionals can help them establish factors within the buy-sell agreement which include the standard of value, the “as of” date, qualifications of the appraiser, the level of value and the funding mechanism. Once business owners agree upon such considerations, the business appraiser is better able to value the company, but problems may arise if multiple appraisers cannot agree upon a value, which can prolong the transfer of shares or interest.
Funding Mechanism
Two major funding mechanisms of a buy-sell agreement are life insurance and a promissory note.
Life insurance is typically purchased by a company or the actual owners to fund a BSA in the event of death. A key issue to clarify when using life insurance as the funding mechanism is whether or not it is considered a corporate asset. The treatment of life insurance as a corporate asset could significantly change the value of the business.
Another funding mechanism commonly used is a promissory note. The company and/or its owners can issue a note payable for the buyout, with payments over 7 to 15 years. Items such as terms of the note, down payment, interest rate- fixed or variable, default, etc. must be determined before the triggering event occurs. The payments should not cause the company financial hardship or insolvency.
The BSA should be designed so business owners reach an agreement now, before future triggering events happen. Business owners should engage an attorney, an accountant and a valuation expert to help them develop a buy-sell agreement that clearly addresses for the parties’ intentions, a fair price and a reliable funding mechanism.
Deemer Dana & Froehle LLP offers valuation and consulting services for buy-sell agreements by qualified, credentialed business appraisers. For more information, contact Brad Whitfield, CPA, CVA at bwhitfield@ddfcpas.com
To download the PDF article that was featured in the August 17, 2011 Business In Savannah publication, click here.
